February 10, 2019/Fitch Ratings
Open-ended bond funds are a potential risk to global financial stability given their rapid growth and increasing liquidity mismatches and credit risk, Fitch Ratings says in a new report.
Open-ended bond funds provide daily liquidity for investors but are increasingly investing in longer-dated or lower-quality securities as bank regulation has reduced the supply of market liquidity and investors are seeking extra yield while interest rates remain low. This exposes funds to liquidity pressure if there is a spike in redemptions, potentially leading to forced asset sales and a run on the fund as investors pull out. The risks are most pronounced in purely credit-focused funds with less-liquid underlying assets, such as corporate loans and bonds. We estimate pure credit funds are about 15% of total global bond funds.
A market stress emanating from open-ended bond funds could spread to other financial institutions and affect financial stability, given the interconnectedness among funds, banks, non-bank financial institutions (NBFIs) and the rest of the financial market. Transmission to other institutions could be as a result of market value declines in the types of collateral that they have in common with the funds. Banks and NBFIs could also be exposed through their short-term funding reliance on the funds or other counterparty exposure to them.
Daily pricing for funds invested in less-liquid assets, where pricing quality may be weaker or more subjective, can incentivise investors to “get out first” and leave remaining investors exposed to higher trading costs and less-liquid assets. The use of “swing pricing” (which passes costs associated with fund outflows to the redeeming investor rather than remaining investors) reduces this first-mover advantage but may not be enough to stall a run on a fund. Increased fund regulation, such as stress testing, may help identify sources of run risk, but does not remove them.
Redemption pressure in open-ended bond funds has been limited, although high-yield outflows increased last year. High redemption activity could test extraordinary liquidity management tools, such as limiting or suspending redemptions (“gating”). These tools have helped to contain open-ended fund stress to individual funds or fund sub-sectors in the past, but there is a risk that gating could spark contagion to other funds if it disrupts market confidence. Changes in market dynamics or a combination of idiosyncratic and macro stresses could increase the spillover effects.
Open-ended bond funds have surged since the global financial crisis, fuelled by the effects of quantitative easing and tighter bank regulation. Investment funds (including open-ended and other fund types) grew on average at 12.3% annually between 2008 and 2016 according to the Financial Stability Board’s most recent Shadow Banking Report. About 43% of investment funds were concentrated in the US and 32% in the EU. Bond funds’ assets under management grew to a peak of just under USD11 trillion in March 2018, according to Fitch’s analysis of Lipper data.